Description

I am recommending a long position in Webster Financial Corporation.  Using a sum of the parts generates a target price of ~$50; Commercial and Community Bank is arguably worth current share price of ~$30 and the Health Savings Account (HSA) Bank could be worth ~$20.

A return to ~$50+ will take time and until we have more clarity on credit it is unlikely the stock will get away from you.  I can understand a strategy of waiting to buy and missing the first x% of appreciation while maintaining the potential of earning a significant return.  Unless financials are dead money/value trap forever (which is possible) this “strategy” could at least partially explain some of the significant opportunities/attractive values within financials.

Basics

Webster is based in Waterbury, CT; $32 bn in assets with tangible book value per share of $27.40 and current dividend yield of 5.85%.  Three reportable segments; 1) Commercial Bank, 2) Community Bank and 3) HSA Bank.  For purposes of this analysis I combine the Commercial Bank and the Community Bank.  Webster has the #3 deposit share (~14%) in Connecticut, behind Bank of America (~23%) and People’s United (~15%) with Wells Fargo (~6%) a distant third.  Total loans of $22 bn, 83% loans/deposits, 90% core deposits.  Minimal borrowings.  

Webster is top 5 in the HSA market.  HSAs are tax advantaged - tax deductible contributions and investment returns are tax free - with funds used to pay for medical expenses.  In order to be eligible for an HSA an individual must have a qualifying High Deductible Health Plan (HDHP).  The HSA is owned by the individual and there is no time limit as to when funds must be used.  No need to buy 10 pairs of glasses at the end of the year.  How does Webster benefit from the HSA business?  Cheap Deposits - account holders typically keep the majority of their accounts in demand deposits and aren’t interest rate sensitive.  Fees - interchange fees when account holders spend on medical expenses and account management.  The NIM is lower in the HSA business because the asset side is predominantly securities.

OK, let’s get to the numbers.

Results

Two segments; 1) Commercial and Community Banking and 2) HSA Bank.

Historical Financials:

Commercial and Community Bank

Positive trends over the last several years.  Loan growth compounded 5.5%, increasing NIM, declining provisions, reduced tax rate, stable credit creating increased ROE and generating ~$3.00 in EPS in 2019.  Assuming ~$800 mm of equity, $0 of the preferred equity and $0 of the goodwill are allocated to HSA Bank (arguably conservative), the tangible book value per share for the Commercial and Community Bank is ~$19 as of 2Q2020.

HSA Bank

Interest earning asset growth greater than account growth, increasing NIM, non-interest income growth slightly lower than account growth, declining efficiency ratio creating increased ROE and generating $1.10 in EPS in 2019.  Allocated ~$800 of equity to HSA Bank or ~$9 per share.

Recent Results/Trends

Similar to most regional and super-regional banks.  Increased draws on credit lines and loan deferrals and modifications during the tail end of 1Q.  Decline in deferrals, decline in modifications, repayment of some of the credit lines and originated PPP loans in 2Q.  As an example, as of May 8, 14%, or $2.9 bn, of the loan portfolio had been modified.  Fast forward to the end of Q2 and 11%, or $2.3 bn, of the loan portfolio had been modified.  Approximately 46% of the modifications in the commercial portfolio are non-payment.  Significantly higher provisions in 1Q and 2Q but charge-offs remain relatively modest.  The 1Q provision was $76 mm with $8 mm in charge-offs and the 2Q provision was $40 mm with $16 mm in charge-offs.  The adoption of CECL (Current Expected Credit Losses) as the new provisioning standard added an additional wrinkle.  NPLs as of 2Q were 0.79% of total loans.  Allowance for credit losses was up $92 mm from January 1 to end of 2Q, with coverage increasing from 1.33% to 1.75% over the period.  Even with the higher provisions, Webster remained profitable in 1Q and 2Q and was able to cover its $0.40 quarterly dividend.  Quarterly provisions could increase ~50% from the 1Q level of $76 mm and Webster would still be able to cover its preferred dividend and remain marginally profitable.  Obviously a number of assumptions but generally correct.

It is clearly too early to extrapolate any trends from 1Q to 2Q into the future; one quarter does not make a trend.  I take small comfort in the lower provision, decline in modifications and increased coverage ratio but we are far from out of the woods.  Will update after 3Q report.

Valuation

In a normal-ish world a 10x multiple on ~$3 of EPS for the Commercial and Community bank and a 15x multiple on ~$1.25 of EPS for the HSA Bank seems within reason.  Two primary questions: 1) will there be a capital hole between now and normal? and 2) will normal be a return to something like 2019 and the corresponding trends?  I don’t know and I don’t know.  To be fair, we never know.  So I am placing my bets on probably not and possibly.

My logic as to why now.

Let’s look at what the current stock price is implying.  My starting point is the HSA Bank.  This asset has no credit risk; it is an earnings story.  The multi-year trends remain positive.  High deductible plans are cheaper for employers, HSA accounts are tax advantaged to the individual, more ownership by the patient of health care costs is a positive, etc.  We can quibble about these points but high likelihood that accounts will continue to grow.  Deposit costs will likely remain low, asset yields will likely remain low, usage will fluctuate impacting non-interest income, scale will help with operating leverage.  Overall, EPS in HSA bank will likely trend higher with account growth.  Using reasonable assumptions it is possible this business earns $1.50 - $2.00 within a few years.  Let’s put a 10x multiple on $1.25 in EPS to be conservative.  This implies that the commercial and community bank is being valued at ~$15 or ~80% of tangible book value per share.  Excluding the financial crisis, Webster has rarely traded below 1.0x tangible book.  Webster was also a very different bank during the financial crisis - more of a thrift compared to its current emphasis on commercial banking.  I do understand the obvious that there is still a wide range of possibilities between not so bad and the financial crisis that would be bad for Webster’s stock price.  OK, so let’s assume the financial crisis; tangible book value per share declined ~33% so using a similar drawdown implies a tangible book value per share of ~$12.75.  That implies a stock price of $25 or ~10% downside.  Is the range of 10% downside to 100% upside an attractive risk/reward?  For me, yes.  What if upside is only $40?  Well, the art of investing.

Another way of looking at the business is to assume the commercial and community bank is currently being valued at 1.0x tangible book value per share.  This implies ~$8.50 for the HSA Bank, or ~7x my $1.25 EPS estimate.  Given my belief in the underlying value of the HSA Business this seems very attractive.

I realize sum of the parts is, in many instances, an investors’ dream.  Yes, the math is easy to put together in a spreadsheet and it can tell a story but are the component values ever realized?  Sometimes but not nearly as often as they are used to justify a target.  So, I get it.  I use sum of the parts because HSA accounts are attractive assets (see HQY), transactions do occur and the HSA Bank would be easily separable.  Looking at Webster on a combined basis, ~50% of deposits are near zero cost, non-interest income represents ~20% of total income and ROE should return to low-mid teens in a normalized environment.  Assuming ~$4.00 in EPS a 12x multiple is reasonable.  I like the risk/reward.

Catalyst

Improving/bottom in credit